How often do you consider the market value of your business; what could I sell it for or, did I pay a good price for it? It goes without saying that, for any saleable item its market price is what the market will bear not some notion of its value. You just have to consider the price for a simple terraced house in Kensington compared to the same assembly of bricks, mortar and plaster in Blackburn. These same imponderables apply to a huge extent to putting a value on a business – vitally important if you’re buying or selling it. Just how do you place a value on a business if you’re in the market to buy; or how much should you plan to get if you’re selling?
I have spent decades in the business turn round and D&A (Disposals and Acquisitions) sector and I have to admit that I am still bemused by the price achieved for a basket case or the ludicrously undervalued price paid for a star. But it’s what people will pay – usually based on assumption and presumption rather than hard tangible facts. Trouble is, there often aren’t too many hard tangible facts that can be applied to valuation of a business.
So I am unlikely to be able to provide a faultless guide to valuing a business if you’re buying or selling but I can set out the rules I apply when I am consulted on a D&A activity; rules based on my experiences with successes and some failures.
My guide to valuing a business.
Multiple of earnings.
Any capital purchase made by a company will (or should) be based on a calculation of pay-back. How many months or years of usage will pay back the purchase price? This pay-back will be calculated by assessing the net increase in profit arising as a result of having the facility or equipment etc. Usually referred to as net contribution or earnings, the calculation must be based on the additional profit or reduction in loss that is achieved. So, treating the purchase of a company in exactly the same way, an assessment must be made of what net contribution (earnings) is achieved – what income or increase in profit, as a direct result of acquiring the company. The earnings of the company, so calculated, can then be set against a view of how many years pay-back is acceptable. Because a company is a living entity with opportunity for growth and re-invention and therefore a much longer potential ‘life’ than say a new piece of equipment , it would typically be the case that a longer pay-back is applied.
So, if a continued level of income (earnings) of 5 or more years is acceptable, a multiple of earnings of 5 times would be applied. Simple then; work out the earnings and multiply by 5 and you get the purchase price. A company that is achieving an earnings level of $50k per year would be worth £250k based on a 5X multiple of earnings. Remember that the earnings level is what the company can support in dividends and directors (owners) salary without prejudicing operation of the business.
What is a typical multiple of earnings to use
As a rule of thumb, mainstream businesses in mainstream trading usually do achieve about a 5X multiple. BUT be warned, there are loads of extenuating factors that will grossly inflate or depress a multiples valuation. E.g.
A special asset such as a product or capability you really need access to, or a site with development opportunity or a brand name.
Downside-the lack of market going forward for the particular product. With the advent of electric lighting, I wonder what happened to the valuation of gas mantel companies.
Stock and fixed assets.
Valuation based on multiples of earnings will usually be additional to a valuation of the good old tangible assets – stock and fixed assets. Tangible assets are easy to value in terms of the usage of stock in the production process, the book value of the equipment and the market value of land, buildings etc. But this is an area of considerable risk and opportunity. I managed a MBO (Management Buy Out – where the management team buys the company from the existing owners). Any D&A executor will love MBO’s, nobody knows a business better than its management team and they know where the bodies are buried and where the jewels are hidden. This particular company manufactured electric components that used a lot of wound coils, so they had a lot of wire in stock. But the wire was all obsolete stock of gauge no longer used in the industry so I insisted it all be scrapped and removed from the stock valuation. Perfectly reasonable – yes? However this wire was pure copper of the highest grade and there was tons of it, so whilst it quite legitimately was considered valueless in terms of its contribution to the production process and was written off at zero value, its scrap value was substantial – it paid my fee anyway.
Goodwill is the value placed on the market presence of the business. It can be based on existing customers, contracts and orders but often it is an intangible assessment of the ‘presence’ of the business. And its brand may be the key element. When Rolls-Royce Motors was sold, VW bought the factory, stock, designs etc. whereas BMW just bought the rights to the mark Rolls-Royce Motorcars. So VW paid a price based largely on assets and designs and a multiple of earnings whereas BMW paid a price based on the assessment of the value of the mark with no assets, designs or facilities. I wonder who got the best deal – I really don’t know.
How do you put a value on goodwill. A sweetshop next to a school will have no tangible goodwill but will have evidence of sales based on historic performance. As long as the school isn’t closing down or a competitor opening shop next door, you can assume the same level of business and assess pay-back on these terms. The value of a brand is often anybody’s guess.
Due diligence is the process of auditing all of the tangible and intangible factors in arriving at a valuation. Accounts obviously, to make sure that the declared earnings of previous years are based on accurate figures, but also all of the factors I set out above; the true value of stock, equipment, facilities, the basis of assessment of goodwill and the replacement values of essential facilities. Also key to take note of any drag factors such as onerous supply contracts, tenancy agreements, patent charges etc.
How important are the people in the company – whether you’re buying or selling? If you’re selling, how important are you personally to the on-going activity level. If you are selling up and going to Ulan Battor for a couple of years, can the business function without you? And the converse applies equally. Who must you retain and how do you ensure continuity of staff.
My key points in valuing a business.
Use a multiple of earnings based on how long you intend to run this business to get pay-back or how long you consider reasonable if you’re selling. Anything between 5 and 10 is typical.
Focus in on stock and fixed assets values. Make sure stock valuation is credible, use market valuation of equipment and assets.
Goodwill is heavily subjective. Understand the basis of the assessment, try to apply some scientifically sound method of valuation – historic sales for example.
Due diligence is so called for a reason .Be very diligent in placing vales on everything. Conversely, make sure valuations are defendable.
Key Personnel. Often make or break in a sale is the value placed on key personnel.
Email Blaster UK